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Real Estate agents, flippers, and wholesalers are subject to a nasty tax called the self-employment tax of 15.3% on their income. In this episode, Brandon Hall discusses how to reduce this tax and save thousands by being taxed as an S-Corp.
People who are running full-time real estate businesses are subject to higher taxation on every dollar that they're earning.
S-Corporations and the 15.3% Self-Employment Tax
Up to net profits of $128,400, business owners must pay the 15.3% FICA tax, or the self-employment tax. Above this $128,400 threshold, you only pay 2.9% on every dollar earned. The Social Security portion of the 15.3% drops off.
However, that 15.3% comes into play before we factor in the marginal tax rate from the federal and state perspective. For example, at a federal level of 37% and a state level of 5.5%, that's already 42%. Adding on an additional 15.3% tax is going to put your tax rate above 50% on all income!
This is true for anybody that runs a business where they earn ordinary income. This is generated from performing a service or selling a product. This is active income.
This situation naturally presents more tax planning scenarios, as there is more tax we're trying to avoid. One way to save on taxes is to run your business out of an S-Corp rather than an LLC or C-Corp. The only way to run an S-Corp is to set up an LLC or a C-Corp, and then elect to have the entity taxed as an S-Corp.
An S-Corp is a tax entity, not necessarily a legal entity. It is a federal tax election. They key purpose is not asset protection, but reducing exposure to tax.
Once the S-Corp is set up, you need to set up payroll and begin paying yourself a W2 wage. The key is that only this W2 wage that you pay yourself is subject to that 15.3% tax. The remaining income of the S-Corp is not subject to the 15.3% tax. The difference is that the remaining income is considered a cash distribution or cash dividend, not W2 wages. The S-Corporation route is the only way to achieve this.
Let's say you earn $100,000 with no S-Corp - either as a Sole Proprietorship or an LLC. You're reporting your income Schedule C.
Before we even factor in your marginal tax rate or your state taxes, you're going to pay $15,300 in self-employment taxes alone.
If you were taxed as an S-Corp instead, you may pay yourself $50,000 as a W2 wage and the remaining $50,000 will come out as a cash dividend. Now this $100,000 is split up, and this $50,000 cash dividend is not subject to the 15.3% tax. This equals a tax savings of $7,650.
The first mistakes is that the individual sets up an S-Corp, but the owner still pays themself the entire profit in W2 wages. This is a huge mistake, the entire point of the S-Corp is to not do this!
For financing purposes, most lenders won't consider your W2 from an S-Corp because they know that you own and operate the entire entity. So they're going to look at the entire net income of this entity and consider it self-employment income.
Another big mistake is misunderstand the state tax laws as they relate to S-Corps. In Tennessee and NYC, for example, these areas also tax the cash distributions from S-Corps, likely making the S-Corp a moot point.
The third mistake we see is landlords that put their rentals into an S-Corporation. Landlords generally shouldn't put their rental properties in any sort of corporation. Selling these properties or moving these properties will always cause a taxable event.
The last mistake as it relates to S-Corps is reasonable compensation. The IRS knows that people are using S-Corps to avoid this 15.3% tax. Therefore, the IRS says that you must 'reasonably compensate' the owners of the S-Corp. Don't undercut yourself when paying the W2 wages.
Your CPA will probably take a percentage of net income as the split between W2 wages and cash distributions. But how do you substantiate this? You must find real supporting documentation for wages that you're paying yourself.
Here, we pull all the Bureau of Labor Statistics data relating to the position of the S-Corp position that we're analyzing.
Let's say you're running a software company built mainly on your consulting abilities. Your reasonable compensation will probably be really high.
There are also times where you have things operating very efficiently. Maybe you're making $200,000 in net income, but you're only spending 10 hours a week on the business. We don't want to pay you $180,000, or even $150,000, even if you're the only person in the business. That may be reasonable on the surface level, it doesn't account for the fact that you're only working 10 hours a week. In this situation, we would find a wage on an hourly basis and maybe even make it a premium wage. Don't overlook the fact that you can apply these wages on an hourly basis - you must track your time for this to work.
As always, please consult your CPA before implementing any strategies heard on this podcast.